Stockton, California, the biggest U.S. city to file for bankruptcy, won a judge’s permission to stay under court protection after he found that creditors didn’t negotiate in good faith with the city.

U.S. Bankruptcy Judge Christopher M. Klein in Sacramento rejected arguments from creditors including Assured Guaranty Corp. and Franklin Resources Inc. (BEN) that the city isn’t eligible for bankruptcy and found that creditors “absented themselves from all further discussions” with the city before it filed.

Without bankruptcy court protection, Stockton’s creditors would be free to sue the city in state court, where it’s easier to force asset sales, cuts in city services or a boost in revenue to pay debt. In bankruptcy, Stockton is shielded from such tactics and has more power to choose which bills to pay. Photographer: David Paul Morris/Bloomberg

“Negotiation is by definition a two-way street,” Klein said. “You cannot negotiate with a stone wall.”

The city of 296,000, an agricultural center about 80 miles (130 kilometers) east of San Francisco, is among three municipalities that have said they will try to force creditors, including bondholders, to take less than the principal they are owed. The others are San Bernardino, California, and Jefferson County, Alabama.

No city or county since at least the 1930s has used the power of a U.S. bankruptcy court to force a reduction in its debt principal.

With the bankruptcy petition approved, Stockton can now turn to the process of negotiating with creditors on a so-called plan of adjustment. Creditors can argue later that they’re not being treated fairly, Klein said.

“The city is going to have a difficult time confirming a plan over an objection and claim of unfair discrimination without being able to explain that problem away,” he said.

State Court

Without bankruptcy court protection, Stockton’s creditors would be free to sue the city in state court, where it’s easier to force asset sales, cuts in city services or a boost in revenue to pay debt. In bankruptcy, Stockton is shielded from such tactics.

Before filing for bankruptcy in June, the city asked bondholders and other lenders owed more than $300 million to take less than full repayment. The city listed assets of more than $1 billion and debt of more than $500 million in its bankruptcy petition.

Stockton rode a surge in new-home construction in the 2000s before the housing crash set off a wave of foreclosures that sapped tax-revenue gains. It joined cities across the country using the U.S. Bankruptcy Code to get out from under billions of dollars in obligations they couldn’t afford following the longest recession since the 1930s.

Calpers Negotiations

The city never held talks with the California Public Employees’ Retirement System, or Calpers, which provides retirement plans for city employees. The biggest U.S. public pension fund refused to negotiate with Stockton, claiming that under state law it isn’t authorized to reduce the city’s contributions to the fund.

Klein said yesterday that Stockton didn’t have an obligation to negotiate with Calpers because the city doesn’t intend to impair the pension fund.

“If the city makes inappropriate compromises, the day of reckoning will be the day of plan confirmation, and that’s precisely my analysis with respect to the Calpers situation and the omission of dealing with Calpers,” the judge said.

Calpers Chief Executive Officer Anne Stausboll said in a statement yesterday that the pension fund is pleased with the ruling.

“Today’s action gives the city the opportunity to propose a forward-looking plan of adjustment in the bankruptcy case that will allow them to restore long-term financial stability and to provide essential services to the Stockton community through the city’s valued public employees,” she said.

Bankruptcy Requirements

Creditors claimed the city didn’t meet the requirements for being in bankruptcy. A city must first be insolvent and try in good faith to negotiate a deal with creditors.

Klein said Stockton met both requirements.

“The city has no choice but to negotiate in good faith because it desperately needs to adjust debts in a way that necessarily will force the impairment of contracts,” the judge said. “It makes no sense to think the city is playing some kind of game.”

Assured Guaranty, based in Hamilton, Bermuda, argued in court papers that the city, in an effort to become insolvent, manipulated its finances by refusing to raise taxes and limiting service cuts.

The insurer will be on the hook for tens of millions of dollars in bond payments if Stockton wins permission to eliminate the debt.

‘Falls Short’

Assured said in a statement that the city’s current proposal to creditors “falls short of the fairness requirements” of bankruptcy law. When asked about an appeal, spokesman Jeremy Fielding said the company “will determine our next steps” after receiving the judge’s written ruling.

“Assured Guaranty has a substantial interest in seeing the city emerge from its financial predicament as a viable and sustainable governmental enterprise for the long term,” the company said. “Assured Guaranty looks forward to the city working with it and all the other stakeholders on a collective approach to achieve that goal.”

On the good-faith test, Assured and the other bond insurer in the case, MBIA Inc. (MBI) unit National Public Finance Guarantee Corp., claim the city wasn’t serious about striking a deal during months of pre-bankruptcy talks.

Wells Fargo

Franklin’s subsidiary Franklin High Yield Municipal Fund and Wells Fargo Bank NA filed court papers saying they support the objections of Assured and National Public Finance.

Stockton is slated to stop paying for retiree health care on June 30 as part of a spending plan the City Council approved in June, citing a $417 million unfunded liability. The benefit had allowed workers employed as little as a month to receive city-paid health coverage for life for themselves and their spouses, City Manager Bob Deis said.

“After nine months and millions of dollars in legal fees, the judge validated what we have been saying from the beginning, that the city is insolvent and needs the protection of bankruptcy to adjust its debts,” Deis said in a statement. “The next steps are to confirm a plan of adjustment through the restructuring of our debt, begin the recovery process and move Stockton forward.”

Born in the Gold Rush, Stockton struggled for decades, relying on tax revenue from farming and shipping at its deep- water port on the San Joaquin River. A housing boom in the early 2000s brought a surge in revenue as homebuyers, seeking refuge from soaring prices in San Francisco and Silicon Valley, flocked to Stockton, where starter homes cost around $400,000.

City Construction

The city issued debt to build a gleaming new arena and ballpark on its riverfront and to buy a new City Hall it later couldn’t afford to occupy.

The Stockton metropolitan area last year had the highest foreclosure rate in the U.S., affecting one in every 25 homes, or almost three times the national average, according to RealtyTrac Inc., an Irvine, California-based data provider.

In February 2012, Deis announced the city was on the verge of insolvency from mounting retiree costs, the recession and accounting errors that overstated revenue. It then began three months of talks with bondholders and labor unions that failed, prompting officials to seek bankruptcy.

The case is In re Stockton, 12-32118, U.S. Bankruptcy Court, Eastern District of California (Sacramento).

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